Independent Review into the Future Security of the National Electricity Market Preliminary Report, Dec 2016 (docx 04 mb)

Wholesale electricity costs and their growing dependence on gas prices

Over the next three years, increases in residential electricity prices are likely to be driven by an increase in the wholesale price after a long period in which prices were suppressed by a large excess of supply over demand. This change is caused by the retirement of two large coal-fired generators – Northern in South Australia in May 2016, and Hazelwood in Victoria in March 2017. Rising wholesale gas prices will also affect wholesale electricity prices. This is particularly the case where gas generation sets the wholesale price, as it often now does in South Australia. As traditional generators leave the market, liquidity in electricity financial markets may become a problem, also putting upward pressure on the overall cost of generation.

Gas has the potential to smooth the transition to a lower emissions electricity sector. Gas generation provides the synchronous operation that is key to maintaining technical operability with increased renewable generation until new technologies are available and cost-effective. Furthermore, gas is dispatchable when required.

The role of gas in the NEM’s future generation mix is complicated by events in both domestic and international gas markets. Australia’s east coast gas market was previously quarantined from international markets, but in recent years has transformed into a major liquefied natural gas (LNG) export industry with prices dependent upon international oil prices.

Domestic gas prices have risen considerably and become more volatile due to being dependent on the international price, in conjunction with a tight supply-demand balance and rising costs for the development of new reserves. System security and retail prices are both negatively impacted by the recent increases in gas prices and constraints in gas supply.

Additional gas supplies for electricity generation are needed urgently. Reviews by the Australian Competition and Consumer Commission and the AEMC have identified a range of issues affecting gas market competitiveness. The COAG Energy Council is currently implementing a package of reforms. However, even after they are implemented there will still be uncertainty as to whether sufficient gas will be available to meet future domestic demand. This is due to supplies being diverted to meet international LNG supply contracts, low levels of exploration and forecast production, restrictions on onshore exploration and development in some states and territories, and infrastructure constraints⁵⁸. Tighter gas supply translates to higher gas prices.

Most consumers are not directly exposed to the wholesale electricity markets and these cost pressures. Nevertheless, increased wholesale prices due to the generator retirements and higher gas prices will inevitably flow through to higher retail prices for consumers.

The cost of policies, such as the Renewable Energy Target and premium feed-in-tariffs, are included in all electricity bills. In FY2015 the cost of these policies represented around 6.2 per cent of the average household bill⁵⁹.

Network charges

On average, network charges accounted for 43 per cent of residential electricity prices in FY2015, although the exact share varies between different states and territories. Of this amount, transmission network charges accounted for 7 per cent and distribution network charges accounted for 36 per cent⁶⁰.

Increased network charges were the main driver of recent electricity price rises⁶¹. The Australian Energy Regulator (AER) estimated network operating revenues over the five-year regulatory cycle from 2008 to 2012 at $60 billion – a 30 per cent increase on the cycle before that. This increase was required to replace aging assets, meet stricter reliability and bushfire standards and augment the grid to cope with forecast increases in peak demand that in fact never eventuated. The 2013 Productivity Commission inquiry into electricity network regulation found that the price rises were also “partly driven by inefficiencies in the industry and flaws in the regulatory environment”. It recommended:

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  modified reliability requirements to promote efficiency
  
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  improved demand management
  
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  more efficient planning of large transmission investments
  
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  changes to state regulatory arrangements and network business ownership.⁶²
  

The AER Regulatory determinations made since 2012 have allowed for network investment levels that are on average 25 per cent lower than levels in previous periods⁶³.

Economic regulation of networks

Transmission and distribution networks are natural monopolies – they are capital intensive and their average costs decline as their output increases. Network business are subject to economic regulation by the AER, who determines the amount of revenue that network businesses can recover from consumers. It aims to provide efficient outcomes for consumers and adequate returns on investment for network businesses.

Widespread community concern about the scale of electricity price rises led the COAG Energy Council’s predecessor, the Standing Council on Energy and Resources, to recommend changes to the economic regulatory framework to improve the strength and capacity of the AER to determine network revenue increases, so consumers do not pay more than necessary.

The COAG Energy Council is currently undertaking a review of the Limited Merits Review regime, the process by which the AER network revenue determinations can be reviewed by the Australian Competition Tribunal. Reviews of 25 network revenue determinations between June 2008 and June 2013 increased network revenues by around $3.3 billion⁶⁴. Across the 12 AER decisions which have been the subject of review since 2013, the total additional revenue requested has been of the order of $7.3 billion⁶⁵. The findings of this review will be presented to the COAG Energy Council in December 2016.

Reliability standards

Networks are required to meet reliability standards determined by individual states and territories. For example, state governments in New South Wales and Queensland increased distribution network reliability standards in the mid-2000s following a series of blackouts. This change in standards resulted in a significant decrease in outages, but came at a cost to consumers, highlighting the difficulty in achieving balanced network investment that meets security and reliability, and affordability objectives.

In its 2013 Inquiry Report, the Productivity Commission found that reliability standards were set at higher levels than consumers actually value. It recommended that reliability standards should be set against an examination of the costs that consumers are willing to pay, rather than by prescriptive standards⁶⁶. A review by the AEMC found that consumers value reliability highly but a significant proportion would be willing to accept slightly lower reliability outcomes in return for the cost savings that would result⁶⁷.

Australia’s networks are built to be capable of delivering power to consumers during periods of peak demand, even though this level is reached on fewer than five days each year, generally when air conditioning load spikes. Network investments are made ahead of forecast increases in peak demand to ensure reliability standards are met. The demand forecasts on which network investments from FY2008 to FY2013 were made assumed peak demand would continue to rise, but it did not. Instead, demand reduced as consumers responded to higher prices and policy incentives by improving energy efficiency, reducing consumption and installing rooftop solar.

Peak demand and cost reflective pricing

Preventing increases in peak demand is critical if network driven price rises are to be avoided in future. Cost reflective pricing has been proposed as an efficient method of reducing peak demand. Cost reflective pricing involves charging prices that accurately reflect the cost of providing network services to different consumer groups. This will result in consumers paying for network services according to their peak usage and will provide a financial incentive for consumers to shift their demand, which should reduce the overall size of the peak (see Chapter 2). From 2017 onwards, there will be national requirements for distribution network businesses to ensure that prices are more cost reflective. However, distribution network businesses are also required to comply with any jurisdictional requirements, which may slow implementation. For example, some jurisdictions are introducing cost reflective pricing on an optin basis only.

The AEMC has estimated that cost reflective pricing will result in up to 80 per cent of consumers having lower network charges in the medium term⁶⁸. Analysis by Energeia estimates that there are net economic benefits of $1.8 billion by moving to an opt-out basis from 2021, with an average reduction in network bills of 9.6 per cent by 2026 compared to continuing with an opt-in approach⁶⁹. However, even without cost reflective pricing consumers have responded to investment signals by increasing energy efficiency and by installing rooftop solar and, more recently, batteries. It is possible that this consumer-initiated action will reduce the size of the peak network demand irrespective of cost reflective pricing.